The Role of Exchanges in relation to good corporate governance

Investors in securities (shares and bonds) listed in the stock market buys and sells shares and bonds and in the process benefits from the regulatory framework that listed companies have to follow as part of their listing and continuous listing obligations. But digging a little deeper, one will notice that most investors are unaware of what these regulatory processes actually are and the powers that stock exchanges, such as the Dar es Salaam Stock Exchange (DSE), holds in order to ensure regulations are followed for the purpose of protecting investors interests, up to a certain level. However, with investors knowledge or otherwise, there is, in fact, quite a lot happening in the background that the exchanges pursues with listed companies when it comes to good corporate governance practices, starting with the actual listing procedure — which I covered in lengthy two weeks ago.

In that article, two weeks ago, I also indicated that often times, shareholders of listed companies, in our local environment, do not understand their roles in a company that they have invested into. I indicated that some investors will cut links with the company they have invested into soon after the Initial Public Offering (IPO) process is completed. In future corporate actions such as dividend payments, AGMs, bonus or rights share issuance would not concern them either due to lack of information or lack of interest or both. In some cases, these investors tend to think that it is either the role of the capital markets regulator or the stock exchange to protecting and look into their interests even in matters such as those involving corporate actions. In today’s article I will explain the role of exchange on listing companies, particular in ensuring good governance.

It is true that, the DSE controls the listing process for any company intending to list into the Exchange either in its Main Investment Market (MIM) segment or its Enterprise Growth Market (EGM) segment. Companies applying to list in either of the two segment would have to meet a number of requirements in order to be granted a listing. These requirements ranges from the size of capital, minimum number of shareholders, directors and board committee, to matters pertain to historic results, size of the company, its future outlook and the like. For the EGM listing, requirements are actually less strict as it is meant to facilitate capital raising for small and medium enterprises and newer business ventures with relatively shorter history, smaller amount of capital and few shareholders. Because of lesser stricter listing condition, there is a requirement that companies listing in the EGM also need to have a specialised adviser (a Nominated Adviser) who is trained, licensed and regulated by the capital markets regulator. Such an adviser helps these companies with regulations during the process of listing and after the company has been listed to ensure compliance to listing obligation and good corporate governance practices.

As it is, once listed, companies must then ensure compliance with listing requirements. Importantly, they are required also to comply with Companies Act, which regulates shareholders rights, board meetings, annual general meetings and other company-related issues. Listed companies must also comply to various regulations as stipulated by the capital markets regulator from time to time — key to this are guidelines on good corporate governance. Breach of the act, rules and regulations will not only result to suspension and cancellation of listing — in some cases it is a legal issue and as such becomes a court process. What happens with NICOL is the case at hand. What needs to be noted up to this point is fact that: its is once a company is listed that the DSE can truly begins to manage the process and regulations of its listed companies life. Therefore, prior to listing, listed companies to are required to abide not only with legal requirements of being a business entity but also with listing preconditions. Any breach of these will see the DSE step in and censure such a company.

As an example, listed companies are required to publish their financial results twice a year (interim and year end), with the letter being audited with the auditor that has been resisted with the National Board of Accountants and Auditors (NBAA). Such results should be published within three months of period end and should be published in newspapers with wider circulation. Should a company fail to do so within the required timeframe, the DSE may suspend their listing. Publishing results is a very important part of the process of a listed company to engage and communicate with its shareholders and the general public — it provides information about financial performance results, trading updates, directors’ stake in the company, expected corporate actions such as dividend announcement, etc. This particular activity serves two important purposes in relation to a listed company, apart from informing shareholders and the public, it also serve to provide everybody with access to information at exactly the same time — so as to avoid cases of inside trading and price manipulation. Therefore, it publishing financial results levels the playing field, putting small retail investors in the same shoes as large institutional investors when it comes to access to the company’s vital information. It is for this reason that the Exchange is so very strict about the information being published in the newspapers that has wider circulation.

let us go back to some of the extreme measures that the Exchange can execute in cases of breach of continuous listing requirements including non-compliance to good corporate governance. Upon such incidence(s) some of the disciplinary measures are: placing the company into a non-compliant board, which is a separate trading segment to enable the company resolve the problems before being admitted again the normal board, and if (within 12-months) the company fails to comply or address issues that resulted into disciplinary measure; the DSE may deem it fit to suspend and/or cancel the company’s securities from trading in the Exchange — all this is done in order to protect investors’ interests. Suspension or cancellation means that the company shares can not be traded in the Exchange. Even in such situations shareholders still own the shares and retain all rights (like the case with NICOL), and the entity must continue following other legal compliances as provided in the Companies Act. However, no trading can take place until such a time as the suspension is uplifted or re-application for listing in the case of cancellation.

A listing can be suspended for a number of reasons i.e. accounts manipulation; non-publication of financial results; failure to hold mandatory meetings of the board and shareholders, if there is price-sensitive information that is in the market that hasn’t been published for access by all shareholders and the general public, when the company is declared bankruptcy etc. There are circumstances where a listed company can also request a suspension of trading of its shares in the Exchange by its own, this is when the company feels that there is information in the market that they are not yet able to provide clarity and details on.

Stock Markets — why are they Relevant for any Society?

Stock markets, to some people are often portrayed as casinos. Some of these sentiments are partly informed by news report that will often show frantic traders (particularly in bigger stock markets) speculating on where prices would go next, almost becoming euphoric if the shares have had a good run up (also called a bull market), or thoroughly depressed if the market is down (a bearish market). Indeed it is fair to say that there are many people who treat stock markets as places to make quick money, who spend their lives and sizable amounts of money trying to gain short term trading edge over others, not bothering to understand the underlying fundamentals of the business behind the shares.

The image portrayed above is somehow unfortunate because along side the speculative traders and investors (as opposed to value investors), are millions of value-based investors, (representing retirements savers, pensions funds, insurance funds, etc), who genuinely try to understand the long term prospects for a company, calculating the intrinsic value for it and then deciding whether to allocate money to the firm to help its growth, expansion, building new factory, make new invents, go into new frontiers, etc.

Through the actions of these genuine investors societies gains new products, new industries, creation of employments, creation of wealth, as money is taken from idle and inefficient activities and reallocated to new frontiers and efficient use. As one can imagine, through this process — it is not only society at large that benefits from the presence of stock market in its midst —but it is anyone with savings in a pension scheme, or possess an insurance cover, or have idle cash/savings or an investments with relatively lower returns, etc — will want a portion of that money placed in shares with prospects of high rates of returns (profits and capital gain) over the next few decades.

To meet these societal needs (i.e. capital to finance businesses, investment opportunities, etc) stock markets have evolved through history, especially in the manner in which they are governed and managed, the manner in which they face and manage increased competitions and also the manner in which they evolve with technological innovations and invents that have changed their method of trading so that their trading and securities depository are now much built around sophisticated computer systems that can handle millions of transactions in a day.

As it is, it makes sense to say every society in this age of human history needs diversified level of investors within itself to facilitate and assist businesses growth through the mobilisation of savings into productive use, especially long term enterprises and projects, and many investors would prefer to have the liquidity and vibrancy that is offered by stock markets than the difficulty of finding buyers they need to sell of businesses and shares (or securities) off the organised market.

In the same vein, a society needs people who are willing to take risks — either in establishing new business ventures, or expansing the current business into other new territories, or innovation based on ideas or people with the willingness to provide risky funds to new ventures and ideas. Some financial institutions, by their nature, their model of business and mandates are not willing to accept such risks. Institutions, such as banks — would like to strike deals with companies whereby even if the profit is small or even when the company makes losses, they are still paid interest and the capital advanced to such companies. Also, they usually require collateral so that if business plans turnout to be not as expected, the bank can recoup its money by selling off property or other assets under collateral. Holders of other forms of debt capital such as bonds, take similar low-risk (but also low-returns) deals.

One can therefore only imagine if debt (short term or long term) were the only form of capital available for businesses to be established or for financing their further growth. Obviously, if debt was only the source of finance, then very few businesses would have been established or flourished in such a situation because it would be rare for entrepreneurs and business managers to come-up with investment projects (i.e. a new venture, a new product-line, etc) that would offer the lenders the security they need or the certainty and predictable returns they require. Part of the reason why businesses flourish in various uncertain business and economic environment, is because they are also financed by capital whose source recognise that uncertainty and risk taking is part of the business and investment environment. Such fund providers (investors) therefore factors-in such situations in their capital and investment pricing.

In my argument above, I have painted a picture that says over-reliance on debt is neither sustainable nor recommendable for the long term growth and sustainability of many businesses in many sectors. However, let me also say I appreciate that it is possible for some businesses to be entirely financed by debt capital, i.e. companies with little uncertainty regarding its future income — such as those dealing with water and energy utility may fall under this group, because they are regulated and bills charged to their customers are highly predictable for a foreseeable future. However, despite such situations, even for such companies, whenever analysis for a new project is carried out — issuance of shares, because of its efficient pricing and hence less costly source of capital, might be one of the considered capital source.

Now, consider a company whose business is continuously cyclical, or a business whose sustainability depends on its clients or customers sentiments or depends on whether or external factors beyond their control— can such a business be purely financed by debt?. Probably no — such a business would require part of its finance be debt and partly equity. That is the non-risk takers can finance part of the business and risk takers can finance it partly — naturally risk takers will want high reward for putting their hard earned savings in such an exposure. In exchange to such risk taking — they would want to have their views on who should be on the board of directors of the company, they would want the power to vote down major moves proposed by the managers. They would also want regular information on the progress of the company they have invested into. One important aspect to note is that these holders of shares, in the success or failure of the enterprise, they do act as shock-absorbers so that other parties contributing to the company, from suppliers and creditors to bankers, do not have to bear the shock of a surprise recession, a loss of market share. This is why it is important for any society to appreciate the relevance of a stock market in its midst.

Role of Shareholders in Listed Companies

Often times, shareholders (especially retail/private investors) of listed companies, in our local environment, do not understand their roles in a company that they have invested into. This assertion will particularly be revealed in cases where something has gone wrong with the company, or where there is lack of information from the company about what is happening with such a company, etc. In most of these cases, investors would tend to think, it is either the capital markets regulator or the stock exchange that should reminded of their role. This thinking is both true and wrong — I will explain:

One of the core mandate for the regulator and the stock market is to promote investor education, creating awareness as well as creating public interest in the capital markets financial products. This aims at ensuring that shareholders gain necessary skills to hold the board of directors and management accountable in the manner in which they execute their mandates, as stewards of shareholders/investors interests in the company.

Apart from investor education, the regulators and the exchanges also have the role of carrying out a detailed assessment of any proposed issuance of securities (shares, bonds, etc) to the public prior to raising capital or listing into the stock exchange. Such assessment seeks to establish the extent to which the envisaged offer meet the eligibility requirements for capital raising from the public and for listing into the stock exchange.

Prior to issuance of securities to the public for capital raising purposes, the issuer (the company) is required to prepare the prospectus or information memorandum that provide details of the prospective security and disclosure of the relevant information that will help investors understand the nature of the security on offer, the company behind the security on offer, its strategies, its financial wellbeing, its future outlook, its risks and risk mitigation tools as well as its governance and control mechanisms.

Through prospectus or information memorandum, and during the approval process for the prospective issuer’s prospectus, the regulator and the exchange gets an opportunity to sometimes interrogate the company’s board and management as to the facts stated in the prospectus, challenging their assumptions, ask for further details or clarification on matters that requires more elaboration, require more detailed disclosures (if need be), etc. Once satisfied, the regulator and the exchange will approve the prospectus ready for capital raising and listing of securities into the exchange. Up to this stage of the process, the investing public is not so much engaged. Their involvement will start at a later stage, as will be seen below.

Upon approval of the prospectus for capital raising and for listing and once the process of capital raising and listing is completed; the company’s board and management are then charged with overseeing that the strategy and operation delivery of the company is in line with indicative and with disclosures as per the prospectus or information memorandum with regard to information, as disclosed and projected. The board and management are also charged with an obligation to make public disclosures whenever there are any justified material variation from the earlier disclosed outlook and forecasts/projections. They are also required to ensure that there are regular updates to shareholders. Shareholders, through the board of directors are required to approve such updates and other material disclosures that has operation and financial nature. Such updates, by way of continuous listing obligation and/or good corporate governance code, are also reported to the regulator and the exchange.

Furthermore, the board and management of listed companies are charged with ensuring that there is a sound risk management and controls and that mitigation mechanisms are implemented in timely fashion for smooth business operations.

Up to this point, the role of the regulator, the exchange as well as company’s board of directors and management have been portrayed, admittedly, in a nutshell. What role does the shareholder/investor play in all this?

I started this article by saying that in often cases, shareholders of listed companies tend to think that the regulator or the stock exchange or both has a key role to play whenever companies in which they have invested are not operating or performing to their expectations. However, the truth is, in many cases it is the shareholders who are supposed to contribute to the success or failure of the company to meet its (and) their expectations. What happens is that for many shareholders (especially retail/private investors) they loose touch with the company soon as the Initial Public Offering (IPO) process is concluded. It might be that both the issuer and the investor have a shared responsibility for this. To the opposite, shareholders (of whatever form) are required to increase their engagement with the company in which they have invested their money soon after the IPO process; why and how?

It is the shareholders who selects the board of directors to represent their interest on the day to day operations of the company. As it is, the board, delegates this mandate to management —however the board retains the responsibility of ensuring that there is a smooth business operations and risk management mechanisms through out the company.

By attending in the general meetings (Annual General Meetings or Extraordinary General Meetings), shareholders gets an opportunity to make major decisions impacting their rights, exercising their ultimate control over the company and how it is governed and managed, as well as engaging the company on any other matters of interest to them — this includes selection of the members of the board, appointment of external auditors, approval of audited accounts, etc.

Furthermore, in the current era, particularly after what the World experienced in relation to financial and accounting scandals, fraud and company’s mismanagement — investors are encouraged to approach their investment philosophy with activism, with pushy investing behaviour — for better corporate governance and in creating more value for all shareholders. Activists and shrewd shareholders/investors, compared to passive investors, are what is needed in the current world of investment, especially in a situation “principal-agent relationship” needs further enhancement. That is why — apart from what investors can gain through resolutions and voting in the general meetings, shareholders are in some cases encouraged to informally, through contacts, engage the company by exchanging views and information on strategy, performance, board membership and quality of management. I need to put a caution here; good as it may sound in serving investors’ interests, this informal approach of gathering information and facilitating decision is not preferred, as it may lead to different shareholders receiving unequal information, in particular price sensitive information. However, what is important is that shareholders (retail and institutional) should be fully informed and somehow engaged with the company’s activities and are also given an opportunity to question the board and management on matters of operation and governance of the company in which they have invested in.

Based on the above, it can be argued that shareholders have a key role to play in either the success or failure of their company — it requires their more engagement. Regulators and stock exchanges have different mandates on this matter.

EAC: The State of Stock Markets & the Need for More

The East African region has a relatively shallow and illiquid capital market compared to some markets in both the Northern and Southern parts of Africa. Kenya has by far, the largest and most developed market in the region. The Nairobi Securities Exchange, also being the oldest in the region, being established in 1954 commands almost 70 percent of all capital markets activities in the region, as measured in: number of companies listed in the stock markets, depth of the market, number of investors and the level of market liquidity. Other stock markets, i.e. Dar es salaam Stock Exchange, Uganda Securities Exchange and Rwanda Stock Exchange are relatively smaller and newer, all being established from late 1990s in response to economic reforms that included privatisation of state-owned entities, and the encouraging of private sector to play a focal role in economic activities within these economies, among other objectives.

Before we proceed further, let us take an inventory of where we are: The four markets (Kenya, Tanzania, Uganda and Rwanda) has a total Gross Domestic Product (GDP) of about US$ 140 billion, its stock markets total equity market capitalisation is US$ 40 billion, about 105 total listed companies in the whole region (90 — if we exclude the cross/dual listings effect), bonds listed in the four markets are worth about US$ 6.5 billion. Liquidity (turnover) in the equity listings is at the level of US$ 2 billion per annum (5 percent of market capitalization), liquidity on bonds trading is about US$ 0.7 billion. Our total population is estimated at 140 million people, out of these only about 3 million people have investment accounts with the stock exchanges and central banks (for government bonds investments).

The above data are meant to tell us much about our region and its state of long term finance sources. The data tells us about how little have we made use of the capital markets to finance our enterprises and development projects. How are we currently financing these long term economic activities then? it is via FDIs and Private equities, International Development Financial Institutions, Donor funds, taxes and in a very minimal level, capital markets. As for the short and medium term economic activities and projects, commercial banks have been effective — both in the mobilisation of domestic savings and in intermediating them to finance such activities. We have been not as keen to intermediate our domestic savings to finance our long term enterprises and projects via capital markets.

For emphasis, I will repeat some of the key data here: GDP of US$ 140 billion, total market capitalisation of US$ 40 billion, 90 listed companies, a population of about 140 million people and about 3 million with securities investment accounts. A careful look in what these data tell us is that our corporate enterprises, our local governments, our social and economic infrastructure projects, our people are yet to make better use of stock (capital) markets to finance our enterprises growth or projects. It says that we need to adjust our policies, strategies and plans in this space so that we can properly match the region economic condition with its sustainable sources of finance while at the same we propel financial literacy, financial and economic inclusion as well as the need for sustainability.
We may argue that in most measures — number of listings, number of retail and institutional investors, the size of markets capitalization as well as liquidity, our stock markets are still relatively small, the whole region records less than 5 listings per annum; only Kenya has infrastructure bonds, the whole regional do not have a single municipal bonds; shares and bonds are rarely traded and in some cases gaps between buy and sell orders are large. Usually, trading occurs in few stocks, particularly those representing the majority of market capitalization — majority being — banks, brewery and cement companies. Turnover ratios are still very thin, less than 5 per cent in many markets. As it is, low liquidity implies more difficulty in supporting a local market own trading systems, market analysis, and brokers because business volume is too low. Our share of the Africa’s listings and equity turnover is less than 5 per cent.
Where should we be? how should we understand it? — deep, transparent, and accessible financial markets are vital to supporting economic growth, rising consumer demand, and supporting productive innovation. Vibrant financial markets play a critical role in channelling financial resources (savings) into productive investment and fostering growth of enterprises and the economy. And, to be able to sustainably achieve the level of deep, diversified and liquid markets, a good combination of both banks (providing short-to-medium term capital) and capital markets that provide long term and specialized funds, is critical. Robust financial markets allows countries to move beyond short term, volatile capital flows by attracting longer-term investments that strengthen a country’s economic stability by providing more resilient foundation of capital flows.
However, given the newness of most of our stock markets, coupled with lack of awareness and financial literacy as well as the fragmented nature of of our financial markets, entrepreneurs access to long term capital and the investment capacity of institutional investors participation in the financial markets remains limited among stringent capital allocation decision process and financial markets are therefore small, narrow and illiquid.
Our stock markets suffer from both structural and infrastructural bottlenecks. Privatisation via stock exchanges has been lower than anticipated; the level of awareness is still relatively low; a culture of embracing transparency is still a challenges to many family owned businesses; listing requirements for some markets restricts many businesses from raising capital and listing into these exchanges; trading, clearing, and settlement systems are sometimes slower that usual. Similarly, some markets restrict foreign participation. Such bottlenecks induce inactivity in markets.
Despite these fundamental challenges, returns on our markets have generally been relatively high, even in dollar terms (except for last year, 2015). Therefore these markets represent unexploited opportunities for international investors. There are diversification opportunities that are minimally correlated with global financial systems and its risks. They also represent opportunities for system vendors, global stockbrokers, custodians and financial investment advisers.
The attractiveness of African equity markets can also be attributed to the continent’s fast-paced economic growth and development, buttressed by political stability, stabilizing and growth-oriented policies and initiatives, liberalized business environments, increasing regional collaboration, and positive engagement with multilateral agencies.
But much more needs to be done to improve liquidity and attract more company listings. Key steps include promoting transparent and accountable institutions, providing adequate shareholder protection and investor education, strengthening regional collaboration, and encouraging financial innovation. Governments continuance to support exchanges by way of privatizing public enterprises via exchanges, and by providing an enabled environment, including tax incentives to encourage listing of multinationals, foreign companies and small and medium-size enterprises, is critical to the growth of our stock markets.
On the positive note, however — despite the newness, narrow and illiquid level of our markets, we may need to note that we have undergone substantial changes in past two and a half decades, i.e. in early 1990s there was a single stock market, with less than 30 listings, with the current situation where we have four exchanges and closer to 100 listings is something worth noting; however, we know that we can do better than this.
As a conclusion, as region promotes commercial agriculture, as it promotes industrialisation, as it promotes further infrastructure developments; as region intends to look inward in terms of how we finance our development. Let us remind ourselves that for dynamic and more inclusive economies, we need to improve both the fiscal space (i.e more tax revenues, better management of our public spending, etc) in as much as we closely pay attention and consciously developing our local capital markets so that they become vital sources of long term financial resources mobilisation for our sustainable growth and development.